Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on an article by Mr. Bachelder, with assistance from Andy Tsang, which first appeared in the New York Law Journal.

Stock options have been a part of executive pay at major U.S. corporations for approximately 100 years. They have had an important role for approximately 70 years, starting in the 1950s. They have gone through periods of extraordinary popularity (e.g., the 1990s) and have been less popular during periods when the stock markets were in the doldrums. They survived the change in accounting rules (2006) that now require them to be a charge against earnings. This post examines this history and takes a look at where options are today. [1]

History of Options

The First Half Century. Professional management of major U.S. corporations emerged in the early part of the 20th century. Unlike heirs to family businesses, these professional managers ordinarily did not have a “stake” in the business. Profit incentives and, to a limited extent, rights to purchase stock (including, in some cases, stock options) were awarded to some executives to provide an incentive based on the performance of the employer.

The 1950s. The Revenue Act of 1950 added section 130A to the Internal Revenue Code of 1939, providing that the gain realized by an executive on the exercise of a “restricted stock option” under that section would not be taxed on exercise. Instead, the executive would be taxed on disposition of the shares acquired. [2] During the 1950s both tax-qualified “restricted stock options” and non-qualified stock options (taxable at time of exercise) grew substantially in popularity. Annual dollar limits on grants of tax-favored options, together with other restrictions, have limited the use of tax-qualified options today in the compensation packages of senior executives.

The 1960s. During the 1960s stock options continued to be the most used form of long-term equity incentive award. During this period public corporations began to use, in addition to stock options, another form of long-term equity award—restricted stock. Like stock options, restricted stock awards vest over time, meaning they require continued employment. Unlike performance shares, introduced in the 1970s, restricted shares do not require performance targets to be met in order to vest (see discussion of performance shares below).

Starting in the late 1960s and continuing until the early 1980s the stock markets slowed down. A restricted share award, when it became vested, would provide the executive with value even if the stock price grew little or even declined in value from the award date. This contrasted with a stock option, which provided no benefit to the executive unless the stock price increased from the award date price. Sometimes an executive would receive part of the equity award as a stock option and part as restricted stock. At the end of the 1960s, notwithstanding the development of restricted stock, stock options continued to be the predominant form of long-term equity award.

The 1970s. The relatively static market for stocks that continued through the 1970s and into the 1980s meant that stock options were not producing a great deal of value for many executives. Also, at this time, there was pressure on U.S. companies, such as those in the automotive and electronic industries, to increase productivity to meet competition from outside the United States. In the early 1970s, performance shares were introduced. A performance share award was tied to a performance target. An example would be a targeted cumulative growth in earnings per share over a fixed period of time—three years in many cases. If that target was achieved, the award would vest. These new awards were sometimes granted in addition to stock options and sometimes in tandem with them. (The latter practice ended when accountants concluded that a tandem option/performance share took away the expense-free status of the stock option.)

The 1980s. The stock markets began to improve in the mid-1980s. At the end of the 1980s, options continued to be the dominant form of award notwithstanding the fact that they now “shared the stage” with performance shares and restricted stock. [3]

The 1990s. The market moved significantly upward and by the end of the 1990s it had grown to a level approximately 15 times the market level at the beginning of 1980. Options became by far the most popular form of long-term equity award. Measured by values at the time of grant options appear to have constituted approximately 75 percent of long-term equity awards being made at the end of the decade.

2000-to-Date. With the down-turn in the stock market beginning in 2000, grants of options, still the dominant form of award, declined somewhat relative to grants of performance shares and restricted shares.

Three events occurred in the mid-to-late part of the first decade that adversely affected the popularity of stock options.

1. In 2006, the accounting rules changed, resulting in a charge against earnings for the grant of options.

2. In 2008, with the banking crisis, the market fell abruptly and continued to fall until early 2009 (the Dow Jones Industrial Average dropped from approximately 11,000 in July 2008 to approximately 6,500 in March 2009). The economy entered a deep recession from which it has gradually, but not completely, emerged. The Dow has rebounded to approximately 17,000 (as of the writing of this column). This represents an approximately 160 percent increase from the low in March 2009. It represents an approximately 50 percent increase from the Dow at the end of July 2008, just before the market drop in September 2008.

3. The Dodd-Frank Act, enacted in July 2010, requires a say-on-pay vote for public companies generally. [4] This requirement propelled Institutional Shareholder Services Inc. (ISS) and other proxy advisers into a role with great influence over executive pay. ISS has taken the position that a substantial portion of equity awards should be performance-based. In some situations, as noted further below, ISS has recommended that 50 percent of equity awards should be performance based. In its report entitled, “Frequently Asked Questions on U.S. Compensation Policies” (March 28, 2014), under Q. No. 37, ISS notes that if it determines that a company’s executive compensation program is not satisfactorily linked to performance:

ISS is not likely to recommend a vote for the compensation committee members and/or vote for the management say on pay or equity plan proposal unless the company has provided compelling and sufficient evidence of action to strengthen the performance-linkage to its executives’ compensation and comprehensive additional disclosure.

In that same report (also under Q. No. 37), ISS states that if it finds a “pay for performance” disconnect at a particular company,

a remedy could be for the company to make a substantial portion of [time-vested] equity awards to named executive officers performance-based. A substantial portion of performance-based awards would be at least 50 percent of the shares awarded to each of the named executive officers. Performance-based equity awards are earned or paid out based on the achievement of pre-established, measurable performance targets.

ISS’s position as to performance-linkage in executive pay practices has impacted on boards of directors of U.S. public corporations—especially on their compensation committees. How many members of compensation committees want to risk a no-vote or a withheld vote recommendation from ISS (or other proxy advisers) as to their board membership over the issue of whether options they propose to grant exceed a level that ISS approves? [5]

Current Practices

Today, in contrast to the end of the 1990s, stock options do not represent the dominant form of long-term equity incentive awards. [6] Approximately 50 percent of long-term equity incentive awards made today, measured by values at the time of grant, are in the form of performance shares. [7] The remaining approximately 50 percent is made up of restricted shares and stock options with stock options being in the range of one-half of this remaining 50 percent (i.e., approximately 25 percent of all long-term equity awards). Results of surveys of long-term incentive award practices based on values of awards at the time of grant to senior executives vary depending on a number of survey variables including the size and number of companies surveyed.

To what do we attribute this trend away from the dominance of stock options in the late 1990s? As discussed above, the change in accounting rules in 2006 that made options a charge against earnings and the drop in the stock market after the global financial crisis in the fall of 2008 contributed to a decline in the use of stock options. For the past three years the preference of ISS and other proxy advisers for performance-based awards appears to have become a dominant factor in limiting the use of stock options.

Use of stock options today tends to occur most frequently at companies that anticipate significant growth in stock price over the next several years. There appears to be a growing practice of awarding stock options as part of a “menu” of performance equity awards, restricted stock and stock options. Approximately one-third of major U.S. public corporations appear to use this tripartite format in making awards to individual executives. Those companies using the “tripartite” award pattern may consider that using three forms of award spreads the risk/opportunity for those executives receiving such a package.

Stock and Stock Option Awards Compared: Pre-Tax Gains to Executive After Three and After Five Years

The future of stock options may depend in part on the relative risk and opportunity associated with a stock option as compared to a stock award. Following is a chart setting forth differences in gain to an executive attributable to (i) a stock award and (ii) a stock option award. Both awards are assumed to be of equal value at the time of award. The assumed value of the stock option award is a very rough approximation: producing three shares under the option for every share under the stock grant.

Assumptions:

1. Stock price on date of grant is $1.

2. Stock option has a fair value equal to 1/3 of the stock value on the date of grant.

Award

Intrinsic Value of Award Assuming Stock Price Grows at an Annual Rate of

-5%

0%

5%

10%

15%

After Three Years:

1. Stock Award of 100 Shares

$85.74

$100.00

$115.76

$133.10

$152.09

2. Stock Option Award for 300 Shares

$0.00

$0.00

$47.29

$99.30

$156.26

After Five Years:

1. Stock Award of 100 Shares

$77.38

$100.00

$127.63

$161.05

$201.14

2. Stock Option Award for 300 Shares

$0.00

$0.00

$82.88

$183.15

$303.41

The chart illustrates that it would require an annual rate of almost 15 percent (approximately 14.5 percent to be more exact) in stock price growth over three years and an annual rate of close to 10 percent (approximately 8.5 percent to be more exact) in stock price growth over five years for the executive to “break even” with an option compared to the gain if the executive held one share of stock. Also, if the stock price did not grow, or declined in value, the executive would have no gain realized with an option. With a stock award, the executive will realize whatever value the stock has at the time that it vests. (In making the comparison to a stock option, the chart considers only a restricted stock grant. It does not reflect the risk associated with a performance share award: it may produce less or no value depending on the design and the attainment of pre-determined performance targets.)

Where Do Options Go From Here?

After the “down drafts” of the accounting rule changes, the market decline and the impact of ISS and other proxy advisers, stock options have fallen from their pedestal at the end of the 1990s. For the foreseeable future, they are likely to remain in second or third place in popularity behind performance shares. They are likely to “jockey” with restricted stock for “second place” in prevalence measured by values of awards being made at the time of grant. The future position of stock options and restricted stock relative to one another will depend in part on future growth in stock prices. As shown above in the chart, substantial stock price growth must occur to provide better results for the holder of a stock option than for the holder of a restricted share award. (Again, we are not making a comment on the impact of the risks in attaining performance targets in the case of performance share awards.)

From the standpoint of a public corporation and its shareholders, the grant of a stock option carries with it a number of advantages.

1. Under Internal Revenue Code section 162(m), a stock option is treated as a performance-based award and hence, is not subject to the $1 million deduction limitation imposed on restricted stock by that section. (Most performance shares are excepted from the section 162(m) limitation because they are performance-based.)

2. There is an obvious “extra” motivation to the holder of a stock option to increase the market value of company stock. Unless the price increases, the executive holding the option realizes no gain. (The opposite side of this coin, raised by critics of options, is that an option may encourage executives, in the hope of optimizing their option gains, to take inappropriate risks.)

3. Stock options, when compared with performance shares, are simple to understand. Performance metrics are often difficult for investors to understand from summaries in proxy statements. Also, those metrics may not be easily understood by executives, particularly when more than one target is involved (e.g., a primary target based on the company’s own performance, which is then adjusted by a secondary target, the company’s performance compared to a peer group).

Taking into account both advantages and disadvantages of stock options, for the foreseeable future stock options are likely to continue to have a meaningful role, but not the predominant role they once held in long-term equity incentives awarded to senior executives of major U.S. public corporations.

Endnotes:

[1] A very helpful commentary on stock options is contained in a paper by Kevin J. Murphy. See Murphy, Kevin J., “Executive Compensation: Where We Are, and How We Got There,” in Handbook of the Economics of Finance, George M. Constantinides, Milton Harris and Rene M. Stulz (eds.), 2013, Vol. 2A, Chapter 4, pp. 211-356, at pp. 253-299.(go back)

[2] Revenue Act of 1950, ch. 994, §218, 68 Stat. 142. Successor provisions (with different rules) were included in the Internal Revenue Code of 1954 and the Internal Revenue Code of 1986. The current provisions covering tax-qualified stock options, (now called “Incentive Stock Options”) are contained in section 422 of the 1986 Code.(go back)

[3] For purposes of this column, performance shares and restricted share awards have been treated as including performance share units and restricted share units. A share unit generally represents a contractual commitment, if its terms are met, to deliver a share of stock or, in some cases, the cash equivalent. However, there are important differences between shares and share units including tax treatment and the entitlements that accompany a share of stock versus a stock unit. These differences are beyond the scope of the column. An interesting discussion of these differences can be found in the Compensation Committee Guide (March 2014), published by Wachtell, Lipton, Rosen & Katz, at pp. 28-32.(go back)

[5] ISS has stated that a premium option or an option with performance target requirements may constitute a performance-based award (i.e., if the premium or performance target meets ISS’s standards). See “Frequently Asked Questions on U.S. Compensation Policies,” published by Institutional Shareholder Services Inc. (March 28, 2014), at pp. 15-16.(go back)

[6] The post is limited to a discussion of stock options in the context of long-term equity incentives. It does not discuss long-term cash awards. Long-term cash awards constitute less than 10 percent of long-term incentive awards.(go back)

[7] Prevalence of one or another form of long-term equity incentive can be measured a number of ways. First, as used in the paragraph to which this is a footnote, values of awards at time of grant can be the measure. A second measure is how many of the companies in a given survey (e.g., the S&P 500) make use of the particular form of long-term equity awards. Examples of surveys reporting on the prevalence of different forms of long-term incentive awards are “2014 Trends and Developments in Executive Compensation,” published by Meridian Compensation Partners, LLC (April 2014); “Executive Compensation 2013: Data, Trends and Strategies,” published by Hay Group (2014); “CEO Pay Strategies Report,” published by Equilar (2014); and “The 2013 Top 250 Report: Long-Term Incentive Grant Practices for Executives,” published by Frederic W. Cook & Co., Inc. (September 2013).(go back)

What Has Happened To Stock Options? 2014-10-02T09:05:51-04:00 2014-12-15T14:16:48-05:00Harvard Law School Forum on Corporate Governance and Financial Regulation